Here Is The Latest C&I and Owner-Occupied Real Estate Credit Trends

As they say, bank performance follows credit. Right now banking is good because credit is good.  Credit performance for the second quarter of 2018 improved over the first quarter. While investor commercial real estate has seemed to hit is high point back in 2Q of 2017, C&I and owner-occupied real estate continue to improve. According to our analysis derived from Paynet data, the average probability of default (POD) for small and mid-sized businesses was 2.28%, a decrease of 3.8 basis points, or 1.7% improvement over last year. In this article, we break down the state of credit and highlight some opportunities that banks can use to their advantage.

The State of Credit

Businesses continue to improve cash flow which is serving to make credit more stable and less likely to default. Also, better cash flow and the stronger economy has been increasing asset prices to record levels thereby helping loss given default rates in the U.S. 

Most of the improvements are being driven by tax reform, but stronger sales and improvements in productivity have also played a material part. The business cycle remains expansionary and has been moving around its peak within the range of normal volatility since the 3rd quarter of 2015. Past due loan categories are either at record lows or near their lows of 1st quarter 2006.

Below is the forecasted risk by state that needs to be kept in perspective. While Texas is one of the higher credit risk areas that is supposed to get riskier that is largely driven by the increase in new business activity. This presents a double edge sword for banks as lending opportunities abound but banks need to be careful as the average probability of default is a 3.09% (vs. the 2.28% average). That said, while the state is forecasted to weaken, that is just by 23 basis points. LA, AR, MS, MO, GA and the Carolinas fall into this category as well. 

Of course, knowing your state risk isn’t all that actionable. What you really want to know what is happening on an industry basis each quarter. Banks are not passive investors and don’t have to “take” what the market is giving them. By proactively, focusing credit, sales, marketing, and capital, banks that are paying attention to credit changes can have a huge advantage against community banks and credit unions that are no.

Below, we present the forecasted change in the probability of default for popular community bank industries. As can be seen below, banks with more granularity in their credit grading system and data can dramatically take advantage of these trends both to reduce risk and to gain quality customers.

For example, the probability of default for waste management companies has changed 110 basis points. The expected future probability of default is up to almost 4.0%. If you are not paying attention to that shift, while your model says you are getting a 15.4% return on equity on that loan, you are really getting a 10.5% return. When competing with another bank that has this data, you are going to mistakenly win more of these loans as your competition will have priced these loans higher and/or required tighter credit underwriting.

Conversely, hardware manufacturing, facilities support services, and others, have improved in credit. Here, the forecasted probability of default has improved some 40 to 85 basis points. That means you can price, some 12 to 25 basis points tighter on the loan and still achieve the same return. As a result, banks that take advantage of this data can win more loans where credit risk is improving and over time, have a higher quality portfolio. 

A Cautious Word About The Volatility of Credit

While we track and price to the volatility of credit, it continues to improve as the last recession becomes a distant memory. Liquidity and capital have been inexpensive for so long; credit risk volatility is dampened. For example, the average volatility is 2.20%. This is one standard deviation of credit movement and means in a mildly shocked scenario, your probability of default can go from 2.00% to 4.20%. This is likely accurate if we don’t have a recession. However, as the last recession fades from view and the data moves out of many bank’s ten-year look back window, they will have a skewed view of credit volatility. To put this in perspective, the average volatility of credit for 2008 to 2010 was approximately 16.1%. That means that 2% probability of default credit that you underwrote, might have an 18.1% chance of going into default.

Where The Opportunities Can Be Found.

That said, as long as you believe the economy will continue to expand, there are a host of industries such as funeral homes, pipeline support companies, sports stadiums, space technology, substance abuse hospitals, florists, gaming, and security services where credit risk is above average, pricing is high as a result, the industry is improving and has low relative volatility. This type of lending arbitrage is perfect for the bank that does have a positive view of the markets, is willing to take on more risk in order to produce an above average return.

Conversely, there are a whole host of industries that have low probabilities of defaults, low volatility, limited bank competition and as a result, have above average returns. This segment is perfect for banks that have less confidence in the economy and can handle a lower return now in exchange for better performance later in the cycle. Industries such as pig/sheep/goat ranchers, aquaculture, fruit/nut farmers, and hardware manufacturers all have low credit risk and low volatility and are perfect industries where most banks not looking at the data will overprice thereby giving savvy banks an easy competitive advantage

Conclusion

Credit in the USA remains strong and is likely to improve in the foreseeable future. Tax reform should continue to help businesses, as will lower regulation. However, in any cycle, this is where mistakes get made. Strong cash flow, high asset prices, and a competitive market often lull bankers into a state of complacency. It is times like these where bad underwriting happens that sow the seeds of destruction for many banks. Now is the time to be optimistic, but careful. If there was ever a time in the history of banking to pay attention to the data, it is now. 

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